JP Morgan Crisis

Just want to point out that there is a LOT more to it than simply investing excess deposits by shorting spreads.

(With some simplifications), my understanding of the TL;DR version is:

Part 1: What JPM does - JPM is a bank. They take deposits, and lend them out. A lot of this lending goes to corporates - The size of deposits exceeds the size of good loans that JPM are make, which means there are excess deposits - The CIO invests these excess deposits. A lot of these investments are in corporate debt - Thus, JPM are significantly exposed to corporate credit risk, i.e. if a lot of corporates default, JPM are going to lose a lot of money because they won't get repaid

Part 2: Credit Default Swaps - You can hedge this risk by buying credit default swaps (CDS), which are like insurance policies against bonds defaulting. Basically, if the bonds / loans held by JPM default, JPM will receive a payout from the CDS. - However, you can't buy CDS against every single exposure you have (no one will write you insurance for obscure credit, as the market for it would be too illiquid. There are many other difficulties too) - To solve this, JPM bought CDS indices (CDX), which are essentially a basket of different CDS. The theory here is that on average, if a bunch of the bonds and loans held by JPM default, that basket of CDS will pay JPM back.

Part 3: Marking-to-Market - On the other side of the CDX trade, there is a counter-party (the person who will pay you if your bonds default). If at the end of a day, the credit environment worsens and companies are more likely to default, it means the counter-party is more like to pay you, so they pay you a little money to reflect this risk. This is called marking-to-market (M2M) - Now JPM has a new problem: the CDX they hold are marked-to-market, but the loans they have made to corporates are not, because they are assumed to be held till maturity - This means if the credit environment improves (which is a good thing for a bank), JPM will actually recognise a loss on their income statement. Not good.

Part 4: More CDX - To solve this, in addition to buying some CDX, JPM sell a ton of CDX as well. This is where the Whale comes into play. - The CDX they buy is highly "levered". These are structured so that when the market moves a little, the mark-to-market on the CDX moves a lot. JPM buys a bit of this stuff. - The CDX they sell is "normal". These are structured so that that when the market moves a little, the mark-to-marked moves a little. JPM sells a loaaaaaaad of this stuff. This is why the Whale is called the Whale. His trades were huge.

Idea is that in normal market situations when there are regular, small fluctuations:

small amount x big movement = big amount x small movement (So the two trades cancel each other out)

In adverse market situations (lots of defaults), the trade is structured so that:

small amount x big movement > big amount x small movement (So JPM is hedged against their losses on the loans they made)

Part 5: What Went Wrong (1) JPM's model was wrong, so the whole balancing act described above was incorrectly calculated (2) The market realised what The Whale was doing and knew he needed to make these trades. So they gave him difficult prices to work with, making the balancing act even more difficult

A lot of information to digest, but hopefully this make sense. I find it irresponsible that members of the press, regulators, and politicians have commented on this story without having a clue about what actually happened - it was not a simple case of big bank making risky bets.